Contracts for difference, or CFDs, carry with them extra risks that are not present with traditional paper share trading. At the same time they have features that can make trading them highly profitable for people who know what they’re doing.
The aspect of CFD trading that makes them dangerous is the fact that CFD providers offer leverage. That is, they allow traders to purchase a large amount of CFDs by putting down a deposit that is only worth a fraction of their value. This means that if the price of the instrument that underlies the CFD moves in the opposite direction to the one that you predicted then you can rapidly lose more than your initial capital outlay.
As well as making CFDs risky, leverage also makes them useful for people who want to profit from small short term movements in the price of a share or a currency pair. CFDs allow day traders to make profits without having enormous amounts of capital to invest. They are also suited to day trading owing to the fact that by using the in this way and closing your position before the end of each trading session you will avoid incurring the holding fees that CFD providers charge to anyone keeping a position over night.
While they are well suited to short term traders, there are plenty of ways in which CFDs can be useful for traders who prefer to take a long term approach. An instance of this is pairs trading. This involves buying a CFD that is based on one instrument and selling a CFD that is negatively correlated to the first. An example related to currency would be the Japanese Yen and the Canadian Dollar, which move in opposite directions when there is an oil price movement. By engaging in pairs trading you remove some of the risk associated with one of the CFDs moving in an unpredictable fashion.
Finally, possibly the most popular use for CFDs is as a hedge for your other investments. For example, if you you own some shares that you expect to dip in value before returning to a period of steady growth you could short them with some CFDs. In this way you will often lose less money than if you sold your shares and attempted to buy them back at a later date.
My name is Derek, and I have my Bachelors Degree in Finance from Grand Valley State University. After graduation, I was not able to find a job that fully utilized my degree, but I still had a passion for Finance! So, I decided to focus my passion in the stock market. I studied Cash Flows, Balance Sheets, and Income Statements, put some money into the market and saw a good return on my investment. As satisfying as this was, I still felt that something was missing. I have a passion for Finance, but I also have a passion for people. If you have a willingness to learn, I will continue to teach.